A Transaction Data Study of the Forward Bias Puzzle
University of London, Queen Mary - School of Economics and Finance
Central Bank of Norway
G. d'Annunzio University - Dipartimento di Economia e Storia del Territorio; Centre for Economic Policy Research (CEPR)
November 1, 2010
Norges Bank Working Paper 2010/26
Using ten years of FX transactions data we demonstrate that a large share of the FX forward discount bias can be accounted for by order flow. A simple microstructure-based decomposition suggests that order flow creates a timevarying risk premium that is correlated with the forward discount. The order flow related risk premium is particularly important in currency pairs traditionally associated with carry trade activity, as for these crosses it accounts for more than half of the forward bias (with the rest accounted for by systematic forecasting errors). We also find evidence that order flow is partly driven by carry trade activity, which is itself is driven by expectations of carry trade profits. However, carry trading increases currency-crash risk in that the carry-induced order flow generates negative skewness in FX returns.
Number of Pages in PDF File: 37
Keywords: Forward Discount Puzzle, FX Microstructure, Carry Trade, Survey Data
JEL Classification: F31, G14, G15Accepted Paper Series
Date posted: January 9, 2011
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